9.4 Fiscal Stabilization Policy

Question 1

Is fiscal stabilzation policy fundamentally a short or long run policy?

Answer 1

Fiscal stabilization policy is fundamentally a short-run policy. In response to various shocks that cause changes in real GDP, the government may use various fiscal tools in an attempt to push real GDP back toward potential output.

Question 2

What are the alternatives to using fiscal stabilization policy?

Answer 2

The alternatives to using fiscal stabilization policy are to wait for the recovery of private-sector demand (a shift in the AD curve) or to wait for the economy’s adjustment process (a shift in the AS curve) to bring real GDP back to potential. The slower these processes are, the stronger is the justification for government to use its fiscal tools.

Question 3

Example of Canadian fiscal stabilization policy.

Answer 3

Canadian federal expenditure during the Second World War rose from 12.2 percent of GDP in 1939 to 41.8 percent in 1944. At the same time, the unemployment rate fell from 11.4 percent to 1.4 percent as the economy boomed.

More recently, the Canadian government dramatically increased spending in an effort to dampen the effects of the major global recession that began in late 2008. Most economists agree that this “fiscal stimulus” contributed significantly to real GDP growth in the 2009–2012 period.

Question 4

What effect does a reduction in tax rates or an increase in government purchases or transfers do the the AD curve and real GDP?

Answer 4

In our macroeconomic model, a reduction in tax rates or an increase in government purchases or transfers will shift the AD curve to the right, causing an increase in real GDP.

Question 5

What does an increase in tax rates or a cut in government spending do to the AD curve?

Answer 5

An increase in tax rates or a cut in government spending will shift the AD curve to the left, causing a decrease in real GDP.

Question 6

In the absence of a recovery in private-sector demand, such a recessionary gap can be closed in two ways. Whats the first?

Answer 6

The first involves the economy’s adjustment process that we saw previously in this chapter. The excess supply of factors at will eventually cause wages and other factor prices to fall, shifting the AS curve downward and restoring output to , as shown in part (i) of the figure.

However, because of the downward stickiness of wages, this process may take a long time. Policymakers may not be prepared to wait the time necessary for the recessionary gap to correct itself.

Question 7

In the absence of a recovery in private-sector demand, such a recessionary gap can be closed in two ways. Whats the second way?

Answer 7

The second way to close the recessionary gap involves an active policy choice. The government can use expansionary fiscal policy to shift the AD curve to the right, as shown in part (ii) of the figure. It would do this by reducing tax rates, increasing transfers, or increasing the level of government purchases.

Question 8

What does the closing of a ressesionary gap look like graphically?

Answer 8

Question 9

What are ways a recessionary gap may be closed?

Answer 9

A recessionary gap may be closed by a (slow) downward shift of the AS curve or an increase in aggregate demand.

Question 10

What is the advantage of using fiscal policy to fix a recession?

Answer 10

The advantage of using fiscal policy rather than allowing the economy to recover naturally is that it may substantially shorten what might otherwise be a long recession.

Question 11

What is a potential disadvantage of the use of fiscal policy?

Answer 11

One disadvantage is that the use of fiscal policy may stimulate the economy just before private-sector spending recovers on its own. As a result, the economy may overshoot its potential output, and an inflationary gap may open up. In this case, fiscal policy that is intended to promote economic stability can actually cause instability.

Question 12

In the absence of a downward adjustment of private-sector demand, there are two ways such an inflationary gap may be closed. What is the first one?

Answer 12

Again, the first involves the economy’s adjustment process. Excess demand for factors will cause wages and other factor prices to rise, shifting the AS curve upward and gradually restoring output to Y* , as shown in part (i) of the figure.

Question 13

In the absence of a downward adjustment of private-sector demand, there are two ways such an inflationary gap may be closed. What is the second one?

Answer 13

Alternatively, the government can use a contractionary fiscal policy to shift the AD curve to the left and close the inflationary gap, as shown in part (ii). The government would do this by increasing tax rates, reducing transfers, or reducing its level of purchases.

Question 14

What does the closing if an inflationary gap look like grapically?

Answer 14

Question 15

How can an inflationary gap potentially be removed?

Answer 15

An inflationary gap may be removed by an upward shift of the AS curve or by a leftward shift of the AD curve.

Question 16

What is the advantage of using contractionary fiscal policy to close an inflationary gap?

Answer 16

The advantage of using a contractionary fiscal policy to close the inflationary gap is that it avoids the rising wages and prices that would otherwise occur.

Question 17

What is a disadvantage of using fiscal policy to close an inflationary gap?

Answer 17

One disadvantage is that if private-sector expenditures fall for some unrelated reason, the fiscal contraction may end up being too large and real GDP may be pushed below potential, thus opening up a recessionary gap.

Question 18

When is the case for using discal policy to stabilize real GDP stronger?

Answer 18

The case for using fiscal policy to stabilize real GDP is stronger when the economy’s adjustment process is slow to operate.

Question 19

What would happen if many people decided to start puting a greater ratio of their disposable income into savings as opposed to consumption?

What is the Paradox of thrift?

Answer 19

In our macro model, an increase in the country’s total desired saving would shift the AD curve to the left and reduce the equilibrium level of real GDP in the short run.

Thus, frugality on the part of individuals, which may seem to be prudent behaviour for each individual taken separately, ends up causing an economic recession.

This phenomenon is known as the paradox of thrift—the paradox being that what may be good for any individual when viewed in isolation ends up being undesirable for the economy as a whole.

Question 20

What are the policy implications of the paradox of thrift?

Answer 20

The policy implication of this phenomenon is that a major and persistent recession can be battled by encouraging governments, firms, and households to reduce their saving and increase their spending. In times of unemployment and recession, a greater desire to save will only make things worse for the overall economy. This result goes directly against the idea that we should “tighten our belts” when times are tough.

Question 21

Why does the paradox of thrift only apply in the short run?

Answer 21

The paradox of thrift applies to shifts in aggregate demand that have been caused by changes in saving and spending behaviour. That is why it applies only in the short run, when the AD curve plays an important role in the determination of real GDP.

Question 22

What are the short-run and long run implications of the paradox of thrift?

Answer 22

The paradox of thrift—the idea that an increase in desired saving reduces the level of real GDP—is true only in the short run.

In the long run, the path of real GDP is determined by the path of potential output. The increase in saving has the long-run effect of increasing investment and therefore increasing potential output.

Question 23

Why are the fiscal policies that we have been discussing referred to as discretionary?

Answer 23

The fiscal policies that we have been discussing are referred to as discretionary because the government uses its discretion in changing its taxation or its spending in an attempt to change the level of real GDP. However, even if the government makes no active decisions regarding changes in spending or taxation, the mere existence of the government’s tax-and-transfer system will act as an automatic stabilizer for the economy.

Question 24

Definition of an Automatic stabilizer

Answer 24

Automatic stabilizer

      Elements of the tax-and-transfer system that reduce the responsiveness of real GDP to changes in autonomous expenditure.

Question 25

What does the governments tax and transfer system provide to the economy?

Answer 25

Even in the absence of discretionary fiscal stabilization policy, the government’s tax-and-transfer system provides the economy with an automatic stabilizer.

Question 26

What is decision lag?

Answer 26

The period of time between perceiving some problem and reaching a decision on what to do about it.

Question 27

What is Execution lag

Answer 27

The time it takes to put policies in place after a decision has been made.

Question 28

What is the differences in time of application between decision lag and execution lag?

Answer 28

The decision lag applies more or less equally to both tax and expenditure policies. The execution lag, however, tends to be considerably longer for expenditure than tax policies.

Question 29

What is the general impact of changes in taxation that are expected to be permanent?

Answer 29

Changes in taxation that are known to be temporary generally have less impact on aggregate demand than measures that are expected to be permanent.

Question 30

What is the magnitude of effect on changes in taxation that are temporary?

Answer 30

In other cases, however, temporary changes in taxes may be quite effective at changing aggregate demand. If the government temporarily increases employment-insurance (EI) benefits to the long-term unemployed, for example, it is quite likely that they will spend a large fraction of the increased benefits and that aggregate demand will increase as a result.

Question 31

For most tax changes, the following general principle is a useful guide for policy:

Answer 31

The more closely household consumption expenditure is related to lifetime income rather than to current income, the smaller will be the effects on current consumption of tax changes that are known to be of short duration.

Or, to use the language that we used when introducing the consumption function in Chapter 6, the more forward-looking households are, the smaller will be the effects of what are perceived to be temporary changes in taxes.

Question 32

What is fine tuning?

Answer 32

The attempt to maintain output at its potential level by means of frequent changes in fiscal or monetary policy.

Question 33

What is Gross Tuning?

Answer 33

The use of macroeconomic policy to stabilize the economy such that large deviations from potential output do not persist for extended periods of time.

Question 34

How can we summarize the effects of changesi n government spending and taxation?

Answer 34

In summary, increases in government spending and reductions in tax rates generally lead to an increase in aggregate demand and thus to a rightward shift of the AD curve, increasing real GDP. In contrast, reductions in government spending and increases in tax rates generally reduce aggregate demand and thus lead to a leftward shift in the AD curve, reducing real GDP.

Question 35

How can increases in government spending on major infrastructure projects effect potential GDP?

Answer 35

Major infrastructure projects, such as bridges, ports, and highways, can potentially increase the economy’s long-run productive capacity. This form of government spending may lead to an increase in potential GDP.

Question 36

How will reductions in tax rate effect potential GDP?

Answer 36

If the government chooses to reduce tax rates, the effect on potential output will depend on which taxes are reduced.

Question 37

How could recuctions in personal income tax rates or GST rate effect Potential GDP?

Answer 37

Reductions in personal income-tax rates or the GST rate may increase individuals’ incentive to work, thus increasing overall labour supply and the level of potential output. However, economic research suggests that this effect is likely to be very small (unless marginal income-tax rates are reduced from a very high level). In this case, the short-run boost to GDP that follows the tax cuts will be largely reversed as the factor-price adjustment process returns real GDP to a (relatively) unchanged level of Potential GDP.

Question 38

How do reductions in corporate income tax rates effect potential output?

Answer 38

Reductions in corporate income-tax rates are more likely to generate an increase in . By providing an incentive for firms to increase their desired investment, cuts in corporate income-tax rates are likely to increase the economy’s capital stock and, through this channel, to increase its long-run growth. In this case, the short-run boost to GDP that is caused by the tax cut is not entirely reversed in the long run; even after factor prices have fully adjusted, the economy will return to a higher value of . In this case, the fiscal expansion will have improved the economy’s long-run growth.